Tax treatment of doubtful debts and debt write-off

Relevant Legislation and Standards

Income Tax Act
IFRS 9 (for financial reporting purposes)

Section 11(j) of the Income Tax Act 58 of 1962 (the Act), as amended, provides for an allowance of doubtful debts in respect of trade debts of the taxpayer.

The amount of the allowance granted is in respect of a provision that is treated as a deduction in the current year of assessment and reversed and included in the income in the following year of assessment.

Prior to the amendment, SARS applied the discretion granted in terms of section 11(j) and, in practice, gave an allowance of 25% of the face value of doubtful debts.

With effect from 1 January 2019 and in respect of years of assessment commencing on or after that date, the discretion awarded to SARS in granting the allowance was removed and replaced by a set of criteria for claiming the allowance for doubtful debts.

The provision for doubtful debts was on an estimated percentage of the total balance of accounts receivable. The proposed recommendations require a company to review the recoverability of individual debtors based on the risk as reported in the debtors age analysis. Companies and banks can also use a risk model to determine the recoverability of the trade debtors in compliance with IFRS 9.

The new criteria for doubtful debt allowances depend on whether or not the taxpayer accounts for its trade debtors in terms of IFRS 9.

A definition of “bad debts” is:

Bad debts are tax deductible if the debt relates to an amount that has been included in the taxpayer’s taxable income in any tax year if it is due at the end of the year of assessment. A tax allowance is also provided for in respect of specifically identified doubtful debts. Any bad debts arising on loaned money is deductible if it was lent in the course of a money-lending business.

Arising from legislation two methods of application are possible: those not based on use of IFRS 9 guidelines (therefore only the Income Tax Act) and those based on use of IFRS 9.

Where a creditor and a debtor enter into an arrangement whereby debt is cancelled or waived, such an arrangement is a concession or compromise as defined in the Income Tax Act. A concession or compromise is a debt benefit which carries income tax consequences.

The term debt is defined in the Income Tax Act as “any amount that is owed by a person in respect of:

(a) expenditure incurred by that person; or
(b) a loan, advance or credit that was used directly or indirectly, to fund any expenditure incurred by that person, but does not include a tax debt as defined in section 1 of the Tax Administration Act;”

The income tax consequences for the debtor in relation to such a transaction will depend on the purpose for which the debt was used. If the debt was used to fund a capital asset, on which no allowance/s can be claimed e.g. land, then paragraph 12A of the Eighth Schedule of the Income Tax Act is applicable.

If the asset is still on hand at the time the debt benefit arise, the base cost of the relevant asset must be reduced by the debt benefit amount. The debt benefit amount will be the amount cancelled or waived.

With effect from 1 January 2019, if a debt is cancelled or waived in respect of a capital asset that was disposed of in a year of assessment, before the year of assessment in which the loan is cancelled or waived, then the income tax consequences for the debtor will be determined as follows:

• The capital gain or loss previously calculated on the asset, should be recalculated as if the debt benefit and any other debt benefits occurred prior to the disposal of the asset.
• The recalculated capital gain or loss is then compared to the original capital gain or loss and the difference between the two will be taxed as a capital gain in the year of assessment in which the debt benefit arises.

If the debt was used to fund a capital asset on which allowances are claimable and that asset was not disposed of in the year of assessment prior to the year in which the debt benefit arose, then the base cost of the asset is reduced by the amount of the debt benefit. Once the base cost of the asset has been reduced to nil and the debt benefit amount has not been exhausted, the excess amount will be taxed as a recoupment.

With effect from 1 January 2019, in the case where the allowance asset was disposed of in a prior year of assessment and the debt benefit occurs in a different year of assessment as the disposal, then the total debt benefit amount is calculated as follows:

• The recoupment that was previously calculated on the disposal of the allowance asset is recalculated as if the debt benefit was taken into account on recoupment of the asset
• The recalculated recoupment is compared to the original recoupment calculated on disposal of the allowance asset and is taxed as a recoupment.
• If the disposal resulted in any capital gain or loss, in addition to the recoupment then the calculation discussed above in relation to capital gains or losses will be applicable.

Debtors

If taxpayers DO NOT apply IFRS 9 for financial reporting purposes, they must review and analyse the debtors age analysis.

The deductions for tax purposes are as follows:

i) 40% of the face value of doubtful debts that are at least 120 days past the due date are allowed as a deduction; and
ii) 25% of the face value of doubtful debts that are at least 60 days past the due date, excluding doubtful debts that are at least 120 days past the due date, are allowed as a deduction.

Companies generally have a credit policy that details the terms and conditions of the credit granted to debtors. These include the time period within which a debt must be paid (usually at the end of 20 or 30 days). The counting of the 60-day or 120-day period commences after the expiry of the official credit terms: the day following expiry of the credit term.

Summary:

A lot of outstanding debts may not be recognised as doubtful debts and are not eligible for tax allowance if they are outstanding for fewer than 60 days.

Different situations will have different doubtful debt implications, it depends where the bulk of the debt lies.

A company could apply to SARS for a higher percentage of doubtful debt allowance if the debt falls in the post-120-day category. The taxpayer can apply for a directive so that the 40% doubtful debt
allowance be increased to an amount not exceeding 85%.

SARS would consider the following factors before deciding on the size of the doubtful debt allowance:

The history of a debt owed to that taxpayer, including the number of repayments not met and the duration of the debt;
Steps taken to enforce repayment of the debt;
The likelihood of the debt being recovered;
Any security available in respect of that debt;
The criteria applied by the taxpayer in classifying debt as bad; and
Such other considerations as the SARS commissioner may deem relevant.

Tax treatment of doubtful debts in terms of IFRS 9

Taxpayers applying the IFRS 9 for financial reporting purposes must determine the loss to impairment of debt.

This is referred to as the Credit Loss Estimate (ECL), which excludes receivable leases.

The doubtful allowance claimed is 40%:

Of the IFRS 9 aggregate loss allowance relating to impairment that is measured at an amount equal to the lifetime expected credit loss;
Of the amount of bad debts that have been written off for financial accounting purposes as bad debts, where the amounts written off do not meet the requirements of section 11(i) of the Act to qualify for a deduction.

The allowance for these non-deductible written-off amounts is not intended to cover the partial write-off of debt.

25% of the difference between the IFRS 9 loss allowances relating to impairment and the IFRS 9 loss allowance in respect of which 40% tax allowance is determined be allowed as a deduction.

Tax Professionals are advised to obtain a copy of IFRS9 and have a clear understanding of the detailed standard. An overview of the standard can be read here:

https://www.ifrs.org/issued-standards/list-of-standards/ifrs-9-financial-instruments/
https://www.ifrs.org/supporting-implementation/supporting-materials-by-ifrs-standards/ifrs-9/

Author Craig Tonkin

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